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JP Morgan has an interesting take on the stupendous recent rally in the credit default swaps (CDS) of countries such as Poland and Hungary which are considered emerging markets, yet are members of the European Union. Analysts at the bank link the moves to the EU’s upcoming ban on “naked” sovereign CDS trades — trade in CDS by investors who don’t have ownership of the underlying government debt. The ban which comes into effect on Nov. 1, was brought in during 2010 after EU politicians alleged that hedge funds short-selling Greek CDS had exacerbated the crisis.

JP Morgan notes that the sovereign CDS of a group of emerging EU members (Bulgaria, Croatia, Hungary, Lithuania, Poland and Romania) have tightened 100 basis points since the start of September, while a basket of emerging peers including Brazil, Indonesia and Turkey saw CDS tighten just 39 bps. See the graphic below:

Spread tightening was of a similar magnitude in both groups before this period, JPM says (the implication being that traders have been selling some of their “naked” CDS holdings in these markets ahead of the ban):

The past few weeks have seen large moves in EM sovereign CDS that are in the EU compared to peers, in what we interpret to be the initial market reaction to the upcoming regulation…It seems reasonable to conclude that some of this effect is due to the short-sale regulation which only affects EU sovereigns. We can see this trend of EU EM sovereign CDS outperforming peers continuing over the coming weeks to November 1st.

Not everyone buys into this theory. Rob Drijkoningen, head of emerging debt at ING Investment Management, attributes the gains to the improvement in the euro debt situation last month (in fact JPM too acknowledges this as a possibility). Drijkoningen is inclined to downplay the impact of the regulation on central Europe, even though he, like many other fund managers, sometimes does use sovereign CDS as a “proxy hedge” when he holds corporate debt from that country. He says:

It could be harder to continue doing this. If you hold a Polish corporate bond it’s not clear that holding a sovereign Polish CDS as a proxy would be considered a naked CDS trade.

That seems a common enough practice. But there was also another big change in September that might at least partially account for the exodus from sovereign regional CDS — the launch by Markit of the first CDS indices for Latin American and emerging European corporate debt. So investors can for the first time hedge their exposure to an emerging market company via an index which will inevitably ensure more liquidity than individual-name corporate CDS. It also reduces the need to buy sovereign CDS to hedge the corporate. Drijkoningen says:

We mostly use CDS indices rather than individual names in EM debt space. Now that there are corporate CDS indices, it will make it easier to hedge exposure to corporates rather than using proxy hedges.